Fiscal Space under Demographic Shift

In this paper we analyze the implications of demographic shift for an economy's fiscal sustainability through lens of fiscal limit and space. We formulate a stochastic dynamic general equilibrium, overlapping generations model to measure fiscal space in terms of budgetary room between the current and maximum tax revenues (the peaks of Laffer curves). We calibrate the model to Japan and US data and conduct a quantitative analysis. Our findings are summarized as follows. First, the size of fiscal space varies greatly over time and across countries, depending on the underlying demographic structures. Second, the fiscal space and limits will shrink sharply by the mid of 21st century as their population ageing accelerates. In particular, our model calibrated to Japan indicates that the increase in dependency ratio from around 40 percent in 2010 to over 70 percent in 2040 will leads to a contraction in the capital-labor fiscal space by around 36 percent. The fiscal limit will be reached when factoring in the increased fiscal cost of age-related commitments.